It is ironic that stocks are at five year highs going into what is probably going to be the biggest disappointment of an earnings season since the 2008 financial crisis. We got a hint of 4th quarter results during the disaster which was the third quarter earning`s season where most companies missed on the revenue side, and those that beat EPS guidance, did so barely, and most of that was created through stock buybacks and creative smoothing techniques.

Make no mistake when a public company sets earning`s guidance these are numbers that are very conservative, and they expect to blow these numbers away given a healthy business environment. When a company just barely hits or beats the EPS number and misses on revenue, you know they were buying back stock and trying any possible financial trick to attain the EPS number, which is one of the oldest tricks on Wall street, besides giving easy guidance, so that when it comes time for earnings the stock shoots up from “beating” expectations.

The fact that companies have to struggle so much just to meet expectations tells how bad things are from a corporate profit standpoint. They have cut their operations to the bone for the last three years, and built earnings up from the bottom, and that strategy has reached its point of exhaustion. No more to be squeezed out of that cost cutting strategy.

The Fiscal Cliff

Moreover, with the continual uncertainty coming out of Washington from a policy perspective (code word: Fiscal Cliff) it`s unlikely that CEOs committed much towards year-end discretionary CAPEX purchases which would spur corporate growth during the fourth quarter. So expect to hear the term Fiscal Cliff during earnings season quite a lot as the primary excuse for business headwinds by the executive teams during conference calls.

Deja Vu

Last quarter stocks were at these same levels and companies started missing; no one wanted to sell hoping that they would get better earnings reports, but firms just kept missing, and getting taken down one by one while the market stayed afloat at elevated levels.

Then more and more firms were missing on the same days, the big boys started missing, and finally the shorts were going to take multiple firms' stocks down on the same day. Wall Street pumpers threw in the proverbial towel on an options expiration Friday of all days, and took prices down to the next level in most stocks.

In other words, they tried to ignore the bad earnings and keep the rally alive, but the shorts are going to punish bad earnings regardless of bullish sentiment.

Expect the same pattern of behavior as most fund managers are sheep and too stupid to actually get out before earnings season starts, and buy after the inevitable sell-off. They wait and hope and once one big player unloads, they all run for the exits at the same time leaving quite a carnage in stocks along the way.

One benefit is that short sellers can get some very cheap puts and establish some very attractive entry points for the inevitable ride back below 1400 in the S&P 500.

The Debt Fight

Moreover, with the upcoming fight over increasing the debt limit just around the corner, expect quite a sizable selloff in markets which sends everybody back into the comforts of bonds teasing bond vigilantes once again, and reminding everyone, including the Fed, that we really are still in a deflationary, deleveraging cycle that will not turn until true growth based upon sound financial principles are in place in Washington.

Washington is the biggest reason this economy has taken so long to recover from the financial crisis in 2008. And their ineptitude has caused the Fed to overcompensate with an unprecedented and borderline extreme monetary solution which remains to be seen what the eventual unintended consequences are of said policy.

As this is new territory for the Fed, as well as a grand experiment, economists will be analyzing for the next 50 years of academic study as to the ultimate costs and benefits to our society.

Cost Cutting Versus Top-Line Growth

Corporations have had to watch costs the last three years, work their employees longer hours, control costs from an operational standpoint, i.e., operate more efficiently, take advantage of low financing and borrow costs to manufacture earnings where they can throw stock buybacks and creative use of capital.

But the one thing that hasn`t been present for corporations is an environment where the economy is robust, and now we are adding 500,000 jobs a month to the economy, and they can afford to hire and grow profits from the top line through new growth opportunities.

Expect to see the fourth quarter earnings season reflective of squeezing all that can be had from the bottom line over the last three years, as well as the lack of true growth opportunities, which showed its ugly head during the third quarter earnings results, make a pronounced appearance this earnings season.

Fund Managers are Slow Learners

Stocks will get hit hard as shorts take down the earnings misses one by one, until the fund managers get the hint, and start selling before the shorts eat into their profits, and start dumping everything mid-way through this earnings season.

The excuses will be prevalent, all pointing to a lack of certainty out of Washington, but the real reason is that you can only cut your way to profits for so long before you need actual real growth in the economy, and apart from the slight uptick from the bottom in the housing market, the rest of the economy is just not robust enough to produce earnings growth that is reflective of top line opportunities.

Disclaimers: GuruFocus.com is not operated by a broker, a dealer, or a registered investment adviser. Under no circumstances does any information posted on GuruFocus.com represent a recommendation to buy or sell a security. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The gurus may buy and sell securities before and after any particular article and report and information herein is published, with respect to the securities discussed in any article and report posted herein. In no event shall GuruFocus.com be liable to any member, guest or third party for any damages of any kind arising out of the use of any content or other material published or available on GuruFocus.com, or relating to the use of, or inability to use, GuruFocus.com or any content, including, without limitation, any investment losses, lost profits, lost opportunity, special, incidental, indirect, consequential or punitive damages. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. The gurus listed in this website are not affiliated with GuruFocus.com, LLC.
Stock quotes provided by InterActive Data. Fundamental company data provided by Morningstar, updated daily.